Stock Options 101: Terminology, Types & Tax Treatment

October 24th, 2023 by Blake Pinyan

Navigating the world of Stock Options can be a thrilling yet intricate endeavor. While expertise isn’t a prerequisite, a foundational understanding proves invaluable, particularly if you’ve been awarded or anticipate being granted these financial instruments. In this guide, we’ll demystify Stock Options and explore their allure. We’ll then dissect the two primary types, highlighting their commonalities and distinctions, and culminate with insights from a Financial Planning and Tax perspective.

What are Stock Options?

In their simplest form, Stock Options offer you the opportunity to purchase shares in the company you work for. What makes this concept appealing is that it grants you the right to acquire a stake in the company at a lower price compared to its current market value, effectively allowing you to become a partial owner at a discounted rate. It’s important to emphasize the term “right” because there is no obligation involved. The decision to buy shares is entirely at your discretion, and it’s important to note that it comes at a cost, making it an optional financial move.

The process of acquiring your Stock Options is commonly known as “exercising.” People are typically motivated to invest in this opportunity due to the potential for a substantial financial reward if the company’s share price surpasses the purchase price. The number of Stock Options granted can vary based on factors such as the employee’s role and the company’s size, stage of development, and ownership structure and whether it’s public or private.

Employees may receive grants of hundreds or even thousands of Stock Options. To illustrate the potential financial benefits, let’s consider an example:

• Emily is employed by ABC Company, a privately-held firm with plans to go public in two years.
• On October 8, 2022, Emily was granted 1,000 ABC Stock Options at a price of $5 per share.
• When the opportunity arises (typically after a predetermined “vesting” period), Emily decides to exercise all her granted shares, incurring a cost of $5,000 (calculated as 1,000 shares x $5 per share).

Two years later, ABC goes public, and its shares begin trading at $40 each. As a result, Emily’s stake in ABC is now valued at $40,000 (calculated as $40 per share x 1,000 shares she owns), resulting in a gain of $35,000 (the current share value minus the initial purchase cost). This example underscores the potential financial windfall that can result from exercising Stock Options before a company goes public.

What are the types of Stock Options?

There are essentially two types of Stock Options: Non-Qualified Stock Options (NQSOs) and Incentive Stock Options (ISOs). The fundamental distinction between the two lies in their tax treatment.

Non-Qualified Stock Options (NQSOs)

NQSOs are more commonly offered than ISOs, primarily because they are available to a broader range of personnel, including employees, directors, officers, consultants, and contractors. Taxes become applicable for NQSOs at the point of exercise (when you purchase the stock). The tax liability is contingent upon the price you paid per share (the exercise price) and the fair market value per share on the day of your purchase. Specifically, the latter is subtracted from the former to determine the spread. This spread is then multiplied by the number of shares exercised, and this calculated value is taxed as compensation income, subsequently appearing on your W-2.

Upon exercise, the company is likely to withhold taxes on your behalf as per the provisions in the plan document. The most common method involves selling a portion of the shares at the time of exercise to cover the tax liability. Alternatively, a Stock Swap or direct payment to the company may be employed to settle the tax bill. It is essential to recognize that this withholding is typically done at a flat rate, often referred to as the supplemental income rate, and may not align with your personal marginal tax rate.

This is a critical consideration because exercising NQSOs may result in additional taxes owed when you file your tax return, even if some taxes were initially withheld. It’s important to remember that your company is not privy to your personal tax rate.

To further illustrate these principles, let’s continue with the example of Emily at ABC Company. In this case:

• Emily elects to exercise the 1,000 ABC Company Stock Options granted to her on 10/23/2023, with a fair market value (FMV) per share of $8.
• Her exercise price stands at $5 per share.
• Upon exercise, the spread amounts to $3 per share ($8 FMV – $5 exercise price), resulting in compensation income totaling $3,000 ($3 spread x 1,000 shares exercised) reported on her W-2 for the year in which she exercises her options.

The second instance in which taxes come into play with NQSOs is when you decide to sell your stock. To assess the tax implications, you’ll need one additional piece of information: the selling price per share. Unlike the tax treatment at exercise, the sale of NQSOs is subject to capital gains tax rather than compensation income tax. Before we delve into the calculation, let’s review the capital gains tax rules, focusing on Federal capital gain tax regulations rather than a State as each state has its own version.

To illustrate this point:

• If I purchased 1 share of Apple stock for $100 and later sold it for $300, my capital gain would be $200, and this $200 would be subject to capital gains tax.
• The tax rate applied to this $200 would depend on my holding period, whether it was long-term or short-term.

A long-term holding period is defined as holding the Apple stock for more than 1 year after purchase without selling it, while a short-term holding period is one year or less. At the Federal level, long-term capital gains are taxed more favorably than short-term capital gains.

Before calculating the capital gain (or loss) on your NQSOs, there’s an additional step to consider. Given that you already paid taxes when you initially acquired the stock, you should add that amount to your cost basis, which is the original purchase price. Following this adjustment, you can proceed with the standard capital gain calculation, which involves subtracting the selling price from the adjusted cost basis.

Let’s revisit Emily’s situation to illustrate this process:

• Emily originally exercised 1,000 shares of ABC Company at $5 per share.
• This $5 was her initial cost basis per share.
• At that time, ABC shares were trading at $8 per share, resulting in a $3 spread that she paid taxes on.
• Two years later after acquiring ABC stock, she decided to sell all her shares on a public exchange for $40 per share.
• Since she paid taxes on the $3 spread at exercise, this amount is added to her original cost basis ($5 per share). Therefore, her adjusted cost basis for the capital gain tax calculation is $8 per share.
• Subtracting her selling price ($40 per share) from this adjusted cost basis ($8 per share) yields a capital gain of $32 per share.
• Given that she sold all her shares (1,000), her total capital gain amounts to $32,000 (1,000 shares x capital gain per share). Emily’s holding period for ABC stock was long-term, spanning two years, resulting in a more favorable Federal capital gains tax rate.

There are a few additional points worth noting about NQSOs. They can be transferred to others as gifts or as part of a divorce settlement, assuming they have not been exercised. Furthermore, NQSOs do not have maximum value limits, whereas ISOs do.

Incentive Stock Options (ISOs)

Now, turning our attention to ISOs, it’s important to note that they are less commonly granted compared to NQSOs. This is largely due to the fact that only employees are eligible to receive ISOs, with directors, consultants, and contractors excluded. ISOs come with a more favorable tax treatment compared to NQSOs, but this favorable treatment is contingent on meeting the qualifying disposition period.

The qualifying disposition period stipulates:

• Holding the stock for a minimum of two years from the grant date and
• One year from the exercise date before selling it; both criteria must be met.

By adhering to this timeline, you can change the tax treatment from ordinary income to capital gain, which is generally more advantageous. In Emily’s case (if her options were ISOs rather than NQSO’s), she was granted her options on 10/08/2022 and exercised them on 10/23/2023. In order to benefit from the special ISO tax treatment, she should aim to wait until at least 10/24/2024 to sell her shares. If her exercise date was 09/17/2023, her qualifying disposition date would be 10/09/2024.

It’s typically recommended to wait until after the qualifying disposition date to sell ISOs in order to take advantage of the more favorable long-term capital gain rates. There are a few exceptions, such as the need to sell to address an Alternative Minimum Tax (AMT) liability or in cases where the company’s share price is plummeting with no expectation of recovery, and you wish to limit losses. Nevertheless, waiting until after the qualifying disposition date is widely regarded as a prudent strategy.

It’s important to note that regular taxes (Income, Social Security, Medicare, etc.) are not triggered upon the exercise of ISOs (unlike NQSOs, as we’ve learned). These taxes are incurred upon the sale of the ISOs, and the specific tax treatment depends on whether the qualifying disposition period was met.

I intentionally used the term “regular” taxes to distinguish another type of tax calculation, the Alternative Minimum Tax (AMT). Exercising ISOs may not increase your regular taxes, but it does impact your AMT calculation. While most people no longer need to worry about paying AMT, this adjustment, known as the bargain element, must be reported on your tax return in the year of exercise and could potentially result in an AMT liability.

The bargain element is calculated in the same way as we did for the NQSO spread, and it represents the difference between the fair market value of the stock on the exercise date and the exercise price. In Emily’s case, ABC Company’s stock was valued at $8 per share when she exercised it at $5 per share. The spread we calculated was $3 per share ($8 FMV – $5 price). On 1,000 shares exercised, this amounts to a $3,000 adjustment (bargain element) that needs to be reported on Form 6251 for her AMT calculation.

Having an adjustment for AMT doesn’t necessarily mean you’ll end up paying more in taxes. The AMT calculation is beyond the scope of this article, but it’s valuable for you to be aware of this aspect from an educational standpoint.

When ISOs are sold, they are taxed at the more favorable long-term Federal capital gain rates if the qualifying disposition period has been met. These are the Federal standards; state tax rules vary. Unlike NQSOs, you don’t increase your cost basis for ISOs because you haven’t paid regular taxes on them. Instead, you use your original purchase price to calculate the gain.

In Emily’s case, she acquired ABC stock for $5 a share and sold it for $40 a share, resulting in a capital gain of $35 per share. If she sold her ISOs on 10/24/2024 or later, the $35 per share gain would be taxed at the favorable long-term capital gain rates. Since Emily sold 1,000 shares, her total capital gain would amount to $35,000 (1,000 shares x $35 per share gain) and would be taxed at the preferential Federal rates.

If the qualifying disposition period is not met, her capital gain will be taxed as a combination of capital gain and compensation income. In this scenario, the calculated bargain element ($3 per share) would be taxed as compensation income, and the remaining amount ($32 per share) would be taxed as a short-term capital gain. Specifically, $3,000 would be added to the W-2, and $32,000 would be taxed at short-term capital gain rates, which are less favorable at the Federal level.

A few additional points to remember about ISOs:

1. are that they cannot be transferred to others while the grantee is alive, in contrast to NQSOs.
2. There is a 3-month window to exercise ISOs if you leave your company, and missing this deadline may result in forfeiture.
3. The IRS imposes a limit on the value of ISOs that can be granted to an individual in a single tax year, which is set at $100,000. This calculation is made at the time of the grant award, not retroactively.

Anchor Bay’s Perspective

From the perspective of a Financial Planner and Tax Specialist, there are two crucial takeaways from this article: Stock Options come with both costs and tax implications. In our example, Emily’s investment in Stock Options paid off handsomely, resulting in a significant financial reward. However, it’s essential to understand that not every Stock Option grant is a guaranteed success. The value of the stock can fluctuate, and there’s inherent risk. In some scenarios, the stock price may plummet, and you could potentially lose your initial investment.

Before deciding to exercise your Stock Options, it’s imperative to conduct thorough due diligence. This includes assessing the capital required for the exercise and carefully projecting the tax implications. Developing a well-thought-out strategic plan is a wise approach, or you may choose to seek guidance from a qualified professional to help navigate this complex landscape. Equity compensation, including Stock Options, is intricate and requires intentional decision-making.

While Stock Options can offer substantial financial rewards, they also involve financial commitments and tax considerations. Your success with Stock Options depends on informed decision-making, planning, and understanding the potential risks. Being intentional and well-prepared is key to making the most of this potentially valuable employee benefit.